COLUMN-OPEC cannot sustain high oil prices forever: Kemp

Reuters Staff

7 Min Read

(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, Jan 23 (Reuters) - OPEC’s influence on oil prices is very visible in the short run, but it is less certain that its pricing power can be maintained in the long term, according to a thoughtful review published by Bassam Fattouh and Lavan Mahadeva of the Oxford Institute for Energy Studies.

Fattouh and Mahadeva examine how the cartel’s strategy and power over oil prices have varied over time depending on market conditions and the interaction among OPEC members (“OPEC: What Difference Has it Made?” Jan 2013).

It is a superb review of the cartel’s history and operations since it was founded in 1960 with the aim of securing “fair and stable prices” for petroleum producers.

But the more important question is how the cartel will operate in the next decade, and whether it can sustain the current price level of $110 per barrel.

Past experience suggests it will struggle.

SHORT-TERM RATCHET

Fattouh and Mahadeva argue OPEC’s response to oil price movements is asymmetric: “A key objective of OPEC is to avoid oil prices falling below some level deemed acceptable by its members, rather than to prevent oil prices from rising above certain levels or to set a price ceiling.”

Others have likened OPEC to a tea bag: it works best in hot water, when prices are falling and members are in trouble. When prices are high, members struggle to agree on price targets and sharing output, relegating OPEC to the sidelines.

"In a rising market, OPEC tends to satisfy demand at the available market-determined prices by adjusting its production; it does not attempt to discount its spare capacity to bring prices down," Fattouh and Mahadeva explain (here).

“OPEC countries have been protected by strong barriers to entry, which stem from ownership and control of the bulk of the low-cost oil reserves. By limiting investment in their oil sector, OPEC members can control the future flow of oil supplies into the market. They also shift the burden of meeting the demand for the marginal barrel onto high cost producers.”

LONG TERM COMPETITION

OPEC secured huge price increases in the 1970s and early 1980s by limiting production and shuttering excess capacity. But the result was a surge in competing supplies, a huge increase in conservation in the consumer countries, and mounting discord among OPEC members themselves about how to share out their dwindling share of the market.

Between 1973 and 1985, the cartel’s share of world production fell from 51 percent to just 28 percent. Saudi Arabia’s attempts to defend prices saw the kingdom cut output from 10.2 million barrels per day in 1980 to just 3.6 million barrels per day in 1985 (and exports were less than 2 million barrels per day).

The cartel’s share was cut by rising production from Mexico, Alaska and the North Sea, the rest of the United States, and the former Soviet Union. “The increase in non-OPEC output was a shocking surprise,” according to former MIT Professor Morris Adelman (“Genie out of the bottle” 1995).

Crude demand fell even as supplies rose, as the United States, Europe and Japan made determined efforts to boost energy efficiency and promote alternative fuels.

The question is whether history is about to repeat itself. Following the dramatic escalation in oil prices since 2002, output is rising rapidly in the United States, and oil firms are prospecting intensively for additional supplies across Latin America, Africa, the Arctic and Asia.

The United States and the EU have enacted laws that will result in deep cuts to gasoline and diesel consumption by 2025. Even in transport, their core market, the role of oil-based fuels is coming under growing pressure from cheap natural gas.

“Taxation, climate change and energy security policies aimed at reducing the share of oil in the energy mix can erode OPEC’s position in the long term, resulting in lower revenue streams,” according to Fattouh and Mahadeva.

“This represents a real challenge for OPEC and lies at the heart of a core of the oil market: the rent distribution question. The way in which OPEC confronts this challenge will determine both its future evolution and its position in the oil market.”

SUSTAINABLE PRICE LEVEL

In the 1970s, OPEC’s Long-Term Price Policy Committee aimed to push prices up to the point where they were just under the cost of producing synthetic liquid fuels from coal, which it put around $60 per barrel in contemporary money.

But since 2010, prices have remained far above the cost of competing supplies, such as producing oil from shale ($50-75), tar sands ($55-85), natural gas ($70), or coal ($90) let alone deepwater fields. The financial incentive to develop new supplies outside OPEC is overwhelming.

It seems unlikely OPEC will be able to defend the current price level without accepting a substantial reduction in its market share.

“Between 1973 and 1985, OPEC exercised the ultimate market power by setting the marker price,” Fattouh and Mahadeva conclude. However “by fixing price, OPEC had to live with variable volumes of production. With the continued decline for its oil ... OPEC saw its market share in the world’s oil production fall.”

In the 1980s and 1990s, cartel members were hit by the double blow of falling market share and falling prices. As revenues came under pressure, the organisation was divided by fierce disputes about how to share out production cuts and shut ins among its members to try to prevent prices falling further.

OPEC’s production share eventually recovered to 43 percent in 2011. But the increased market share was bought back by two painful decades of low prices after 1985 which curbed the growth of high cost supplies outside the cartel, while wars, corruption and sanctions helped limit the growth in production among member OPEC members.

After enjoying an enormous run up in oil prices and revenues since 2002, OPEC members must ask whether current price levels are sustainable, or the prelude to another period of low pricing needed to shut down the development of alternatives. (Editing by Alison Birrane)